the exchange rate and the current account · the exchange rate and the current account 87...

84 Michele Bullock, Stephen Grenville and Geoffrey Heenan

The Exchange Rate and the Current Account

Michele BullockStephen GrenvilleGeoffrey Heenan*

1. Introduction

Other papers at this Conference (particularly Pitchford and Blundell-Wignall,Fahrer and Heath) examine the factors that determine the exchange rate. Thispaper explores how the exchange rate impinges on the separate components of thecurrent account in the short run and the part it plays in longer-term balance ofpayments adjustment. In particular, it examines both the effect of the exchangerate on imports and exports and considers the role of the exchange rate in adjustingthe economy to underlying structural changes.

The Australian economy since 1980 is an ideal ‘test bed’ for this. During thisperiod:

• there was an important change of policy regime (the floating of the exchangerate in December 1983);

• the underlying current account deficit increased markedly compared withearlier periods, suggesting that there were important structural changes; and

• there was a wide short-term variation in the current account deficit, whichexceeded 6 per cent of gross domestic product (GDP) three times in thedecade.

The variety and extent of the experience should provide the opportunity to drawsome conclusions about the role of the exchange rate. The distinction betweenshort-term shocks and responses, on the one hand, and the longer-term adjustmentsto structural changes, on the other, provides a theme that will be important inanalysing the variety of experience.1

The main forces driving the short-term movements in the current account wereterms of trade changes and investment shocks. Large swings in the terms of tradeplayed a central role in the activity cycles during the period and their impact showsclearly in the current account. While these terms of trade swings were large, theywere generally reversed and provide evidence that, within a long-term steady,secular decline in the terms of trade, the larger fluctuations are temporary. There

* Reserve Bank of Australia. This paper has benefited from comments and assistance from manycolleagues in the Bank, particularly Adrian Blundell-Wignall.

1. For details of balance of payments developments in the 1980s, see Tease (1990).

85The Exchange Rate and the Current Account

were two major investment shocks which had a powerful impact on the currentaccount.

Among the structural changes, increasing international integration was central.A high degree of integration of the capital account had been achieved before 1980,but during the 1980s both imports and exports rose significantly as a percentageof GDP (see Figure 1). This is a relatively recent phenomenon for Australia.Among the OECD countries, Australia was almost alone in not increasing itsdegree of international integration significantly in the 1960s and 1970s. In thesecond half of the 1980s, the picture changed markedly. Effective rates of externalprotection have been almost halved since 1984. Also, producers have come torecognise the importance and permanence of the change and have begun to adapttheir productive capacity to this new world. The link between protection and theearlier failure of international trade to rise was noted by the 1984 Brookings studyof the Australian economy (Caves and Krause 1984). As well, there has beensignificant (although unfinished) microeconomic reform, encompassing the labourmarket, public enterprises and a wide range of private industries. At the same time,Australia’s external environment was changing, with the emergence of a numberof rapidly industrialising countries in Asia, providing a new source of importsupply and export markets. With the current account averaging nearly 5 per centof GDP during the 1980s compared with 2 to 3 per cent which was the norm inearlier decades (see Figure 2), there was a build-up of foreign liabilities, which

Figure 1: Imports and Exports of Goods(per cent of GDP, 1989/90 prices)

8

10

12

14

16

8

10

12

14

16

Exports

Imports

%

1993

%

19911989198719851983198119791977


rose from around 10 per cent of GDP in the mid-1970s to almost 55 per cent in1992 (see Figure 3).

%%

Total

Debt

0

10

20

30

40

50

0

10

20

30

40

50

1981 1984 1987 1990 1993197819751972

Figure 3: Net Foreign Liabilities(per cent of GDP)

-8

-6

-4

-2

0

-8

-6

-4

-2

0

% %Balance of goods and services

Netincome

Current account balance

19931989 1991198719791977 198519831981

Figure 2: Current Account(per cent of GDP)


Accounting identities suggest that the external sector can be examined fromthree vantage points. Firstly, there is the external balance, focusing on trade ingoods and services. Secondly, there is internal balance, highlighting the relationshipbetween the nation’s current account balance and its domestic saving-investmentbalance. Equivalently, this can be seen as the relationship between income (orproduction) on the one hand and absorption (expenditure) on the other. The thirdapproach focuses on how a surplus or deficit is financed and the accumulation ofclaims on foreigners - that is, it emphasises intertemporal aspects. Each of theseapproaches is valid but the first and second approaches may provide more insightsin short-run analysis, while the third will be important in the longer term. None ofthese relationships imply anything about causation. They are all interrelated partsof a system in which the relative importance of domestic and foreign factors canonly be evaluated against the real world.

Section 2 explores responses to short-term shocks, while Section 3 describessome of the structural changes Australia experienced. Section 4 provideseconometric estimates of imports and manufactured exports. Section 5 uses thefindings of the two previous sections to examine the structural adjustment process.Section 6 examines how foreign liabilities (representing the cumulated currentaccount deficits) play a role in the adjustment process, and looks at the debate onthe sustainability of the external position.

2. Adjustment to Short-Run Shocks

This section takes as its starting point the sort of model set out in Pitchford’spaper at this Conference, and uses the predictions from this model as a guide forcomparing actual current account experience since 1980 in response to the twotypical shocks that Australia experiences: an investment shock and a terms of tradeshock. Of particular interest is the role of the exchange rate in the adjustment tothese shocks. Of course, monetary and fiscal policy influenced the current accountalso, but the main focus of this section is on terms of trade and investment shocks.

2.1 The Framework

The expected response of the current account to the two shocks might besummarised as follows:

• shocks which can be characterised as a rightward movement in the IS curve(e.g. an investment surge) are expected to raise interest rates and the exchangerate, increase the current account deficit and increase domestic output(probably putting pressure on inflation). The role of the current account inthese short-term shocks is to provide the opportunity to ‘spill’ excess demandinto the international economy, ameliorating the problem of ‘bottle-up’discussed in Blundell-Wignall et al. (in this Volume). The exchange rate


change will also shift domestic resources into production of non-tradeables.The more closely the domestic and international goods and services marketsare linked, the speedier and more complete is this process of ‘spilling’ excessdemand (and the less inflationary pressure is on the domestic economy); and

• an adverse terms of trade shock reduces income and, at the same time, altersone set of relative prices (between importables and exportables). For Australia,the shock generally takes the form of an export price change. The reactionshould depend on whether people view the terms of trade shock as permanentor temporary. If permanent, they should begin the process of adaptation tothe fall in income, which will require a lower exchange rate to switchproduction towards tradeables (to offset the deterioration in the currentaccount) and switch domestic demand towards non-tradeables (so as tomaintain domestic balance). If the shock is seen as temporary, consumptionsmoothing considerations suggest that the current account should movetowards deficit by the full extent of the terms of trade shock; correspondingto this change in the external account, savings are temporarily run down toaccommodate the loss of income. No change in the exchange rate is needed,as no ‘switching’ of production or demand is required. In practice, of course,people cannot know whether the shock is permanent or temporary (nor wouldtheir adjustment to a permanent shock be instantaneous) and so a mixture ofthe two responses might be expected.

2.2 Short-Term Shocks in Four Episodes

With these predicted responses in mind, this section examines the short-termadjustment process in action, in four episodes over the past 12 years. Does realityfit the model? Three of these episodes are associated with the three peaks in thecurrent account deficit, and the fourth illustrates a period when there were strongforces tending to enlarge the current account deficit (in the form of an adversemovement in the terms of trade), but this was offset by contractionary incomepressures. The four episodes provide case studies in the two prevalent types ofshocks:

• investment booms - in 1980/81 and 1988/89; and

• adverse terms of trade movements - 1985/86 and 1990/91.

2.2.1 Episode 1: 1980/81

In this period, the current account deficit rose from around 1 per cent of GDPto 6 per cent (see panel 1 of Figure 4). This was driven by a strong rise ininvestment (panel 2), in turn reflecting the ‘minerals boom’ - a surge of optimismset off by the second OPEC oil price increase and the prospect of highercommodity prices (a prospect which was not, in fact, realised). This shock was


Figure 4: Four Episodes

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-1

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80

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80

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120

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120

-4

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90

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110

1.00

1.05

1.10

-6

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-6

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-2

% of GDP

% of GDP

Index

Index

Index

% of GDP

Index

Index

% of GDP

% of GDP% of GDP

1. Current

account

deficit

3. Income,

expenditure &

capacity

utilisation

2. 'Shocks'

4. Real

exchange

rate

5. Export &

import

volumes

Ratio

1979 1981 1983 1985 1987 1989 1990 1992

6. Net

exports

deficit

GNE (LHS)

GDP (LHS)

Capacity utilisation (a) (RHS)

Terms of trade (b)

Private investment

Imports

Exports

Episode 1 Episode 2 Episode 3 Episode 4

equal to nearly 4 per cent of GDP, and so coincides reasonably closely with theexpansion in the current account deficit. Changes in net export volumes, driven byimports increases (see panels 5 and 6), correspond closely in size and timing withthe investment surge.

Notes: (a) Ratio of real GDP to real GDP trend.(b) The deviation of the terms of trade adjusted GDP from GDP(I) as a per cent of GDP(I).


This episode provides an example of a fairly pure, investment shock. Theexchange rate (and relative price changes) were an important part of the adjustmentprocess, helping to ‘spill’ the excess domestic demand into the external sector.

2.2.2 Episode 2: 1984 to 1986

The early phase of this period had the same characteristics as an investmentshock, but looking at the period as a whole, the terms of trade shock not onlydominates, but entirely explains (in a proximate sense) the current account deficitincrease - which amounted to 3 per cent of GDP. While the terms of trade declinewas an important explanation for the 35 per cent fall in the exchange rate, oneelement of the terms of trade shock seems to have been delayed in its effect - theincome-reducing impact of the terms of trade deterioration. Until 1986, this wasoffset by strong expansionary pressures coming from a strong world economy, aboost to investment from a change in factor shares in favour of capital and thebeginnings of asset price inflation. By early 1986, monetary policy was tight andthe income effects of the terms of trade deterioration were beginning to befelt: expenditure growth flattened. Net export volumes rose to offset part of theterms of trade loss, increasing by almost 3 per cent of GDP in 1986.

2.2.3 Episode 3: 1987 to 1989

In this episode, the current account deficit rose from about 3 per cent of GDPto over 6 per cent, reflecting two successive (and related) shocks: a reversal of theterms of trade decline of 1985/86 (which would tend to reduce the current accountdeficit); and an investment surge (which would tend to increase it).

Initially, expenditure and production expanded in concert, despite a very rapidrecovery. As in 1984, there was room for domestic production to meet theexpanding demand (see capacity variable in panel 3). This expansion was initiatedby a terms of trade improvement equal to 3 per cent of GDP, but this wasreinforced by an increase in private investment (amounting to 4 per cent of GDP),driven not only by the enhanced prospects that came with the terms of tradeimprovement, but by business euphoria associated with rapidly rising asset prices.The increase in the current account deficit roughly corresponded to the rise ininvestment. Both these shocks should appreciate the exchange rate, and thiscertainly happened, with a rise in the real trade-weighted index (TWI) of around20 per cent.

2.2.4 Episode 4: 1990 to 1992

This episode was, to a large extent, the reversal of episode 3. The currentaccount deficit fell by around 2 per cent of GDP, with a terms of trade fall equal


to around 2 per cent of GDP and a reduction in private investment equal to6 per cent of GDP (offset to some degree by the expansion of the budget deficitequal to 3 per cent of GDP). There was very little exchange rate movement untillate 1991, probably reflecting the firm stance of monetary policy. Most of theaction was in gross national expenditure (GNE), which fell by around 5 per cent.This can be seen as the dominant force of this episode - a fall in investment andincome opening up a sizeable gap between GNE and GDP (see panel 3), with themain adjustment being driven by income elasticities rather than prices.

2.2.5 Observations

There are interesting contrasts between the two terms of trade declines. In1985/86, the current account deficit expanded by about the same size as the termsof trade shock, while in 1990/91, the current account deficit actually got smaller.Does this contrast correspond with the temporary/permanent dichotomy? Thechange in the exchange rate does not appear to be consistent with this idea; if1985/86 had been seen as temporary (and therefore consumption smoothing wasthe relevant model), the exchange rate would not have needed to change much.However, if the 1990/91 terms of trade deterioration had been seen as permanent,that would have implied a significant exchange rate change, which in practice wasslow in coming. This cannot be explained solely by differences of monetary policystance, as policy was tight in both episodes. The fundamental difference seems tobe in the context of the time: there were a myriad of interrelated expansionaryforces in 1985 (world growth, an investment boom, a change in the wages-profitsshare, optimism about fiscal policy and the beginnings of the asset price boom)which contrasts starkly with the gloomy environment of the 1990/91 episode, withits large fall in investment. These expansionary factors offset the income-contracting effect of the terms of trade fall in 1985. But if these forces were sostrong, why did the exchange rate fall so far? Part of the answer is that it wasreacting to the newly recognised realities of higher foreign debt and the limitedbenefits of the 1980 mineral boom (see Blundell-Wignall et al., in this Volume).

The second comparison is between episodes 2 and 3 where in both cases, therewas a substantial increase in the current account deficit, and a strong rise in bothGNE and GDP. The major contrast here is in the behaviour of the exchange rateand therefore relative price movements. It is here, above all, that the importanceof relative prices in the adjustment process is clear: in 1986, the depreciation andrelative price change was enough to produce a positive change in net exportvolumes which went quite some distance to offsetting the adverse movement ofthe terms of trade on the current account, while in 1988/89 the rise in the exchangerate (and associated change in relative prices) was enough to ‘spill’ much of theincome shock into the external sector - thus expanding the current account deficit.


Other generalisations can be made:

• the exchange rate is effective and plays an important part in changing netexport volumes. In the two investment shocks (1980/81 and 1988/89), theexchange rate was effective in spilling excess domestic demand into theoverseas sector and attracting incremental saving to finance real investment;

• terms of trade shocks generally seem to be seen as permanent rather thantemporary (two characteristics of permanent changes are exchange rateresponses and some adjustment of trade volumes). This seems curious, giventhat these large swings in the terms of trade have invariably proved to be onlypartly sustained, and that the long-term trend in the terms of trade has beenquite modest; and

• where spare domestic capacity existed, GNE increases and GDP increasesmoved more or less in tandem. This suggests that goods and services marketsare not perfectly integrated internationally, as domestic productive capacitywas the first ‘port of call’ for meeting increased demand.

3. Structural Issues

Over the course of the 1980s, there have also been longer-term structuralchanges, which have seen Australian production become much more closelyintegrated with international markets. Merchandise trade volumes rose sharply asa share of GDP from the mid-1980s, following a period of relative stability in the1970s (see Figure 1). Clearly, exchange rates and relative prices, by themselves,cannot explain this simultaneous rise in both imports and exports.

This greater integration is not, of course, a phenomenon confined to Australia.Since 1960, international trade has grown roughly twice as fast as average GDPgrowth in the OECD countries, and this is reflected in the rise in exports as aproportion of GDP in most industrial countries (see Table 1). What is differentabout Australia is how it has lagged the international trends in integration.

In Australia’s case, the most prominent specific policy factor driving thisgreater integration was the reduction in protection. Figure 5 shows the IndustryCommission’s calculation of the effective rate of assistance for Australianmanufacturing.2 It captures tariffs, quotas and other assistance measures whichdistort the relative prices facing manufacturers. On this measure, protection fellsharply in the early 1970s (following the across-the-board cut in tariffs in 1973).Not much more progress was made (in fact, some reversion occurred) until themid-1980s, and since then, another substantial downward movement has beenrecorded.

2. The series shown in Figure 5 is a spliced series. See Appendix A for details.


Table 1: Exports of Goods and Services to GDP

(constant prices, per cent)

1970 1985 1992

Australia 13.9 16.5 22.7

Austria 25.4 40.9 47.3

Canada 21.2 27.0 32.0

France 15.1 23.0 27.1

West Germany 22.5 35.1 44.2

Italy 15.5 20.8 24.3

Japan 8.1 16.2 18.4

Switzerland 28.1 40.7 42.8

United Kingdom 21.5 28.6 30.9

United States 5.6 7.2 11.6

Source: OECD Quarterly National Accounts.

14

16

18

20

22

24

14

16

18

20

22

24

% %

1973 1976 1979 1982 1985 19911988

Effective rate of assistance

Figure 5: Effective Rate of Assistance

At the simplest level, this reduction in protection would be expected to have twoeffects - the exchange rate would depreciate in order to offset the tendency forimports to increase; and, as a result of this, exports would increase. So the


reduction in protection might be one of the explanations for the increase in bothimports and exports. This simple intuition is appropriate in the short run. It maynot, however, be the end of the story. In the longer run, if the distortions imposedby tariffs are very large, removing the tariff increases national income and, likeother increases in productivity, this would put upward pressure on non-tradedgoods prices and thus upward pressure on the real exchange rate. The dynamicdistortions caused by tariffs may be potentially more important than the staticdistortions. A second qualification is that tariffs might impose a sufficiently high‘tax’ on exports (imported inputs costs are higher than under free trade), that ageneral reduction in tariffs might actually improve the trade balance and cause areal appreciation (Johnson 1966). Neither of these considerations, however, altersthe intuition that a reduction in tariffs would be expected to increase both importsand exports.3

The reduction in tariffs is only one example of the significant microeconomicreforms of the past 10 years (and, in these, the tariff reduction would often havebeen an important catalyst). The changes are often attitudinal and unquantifiable,but are reflected in the new-found emphasis on export orientation and ‘world-bestpractice’.4 Many of these reforms have no clear direct balance of payments link(see Forsyth (1990)), but have served to make Australia more competitive andoutward looking. While they cannot be quantified, they form an importantbackdrop to the greater international integration. These changes involved:

• a rise in intra-industry trade;

• rapid increases in manufactured exports; and

• a substantial alteration in the direction of trade, particularly in exports.

3.1 Intra-Industry Trade

Historically, much of Australia’s trade has been between industries - exportingcommodities and importing manufactures - rather than within industries.Lowe (1990) showed that in 1987, intra-industry trade accounted for only 12 percent of total Australian trade, the lowest proportion of any OECD country. In mostEuropean countries and North America, for example, intra-industry trade accountsfor around 40 to 50 per cent of total trade. The structure of Australia’s resourceendowment provides one explanation. Intra-industry trade tends to be lower in

3. Clements and Sjaastad (1984) discuss the theory of import protection, emphasising how muchof the burden is borne by exporters. They also provide empirical estimates of the cost toexporters of protection. Swan and Zeitsch (1992) show, in the context of the ORANI model,that reductions in tariff protection result in increases in manufactured exports.

4. McKinsey & Company (1993) document the recent emergence of this export culture in manysmall and medium-sized firms.


goods which are relatively homogeneous - for example, commodities. Australia’slarge weighting towards these types of exports would, therefore, tend to decreasethe amount of intra-industry trade as a proportion of the total.

Trade structure is not, however, the whole story. Lowe shows that even for tradecategories in which intra-industry trade is prevalent (in particular, manufacturedgoods), Australia’s intra-industry trade is much lower than the average. Animportant factor here has undoubtedly been protection of the domesticmanufacturing industry in Australia. With reduced protection, intra-industry tradeshould expand. Indeed, while the share of intra-industry trade in total Australiantrade remains very low, it has risen, particularly over the past decade, to levelsnearly three times higher than 25 years ago (see Table 2). Individual industriesshow a more dramatic change. Intra-industry trade in the broad category ofbeverages and tobacco has risen from about 7.5 per cent in the 1960s and 1970sto almost 40 per cent at the beginning of the 1990s. The Closer EconomicRelations Agreement has led to a dramatic expansion of intra-industry trade withNew Zealand. Around 45 per cent of Australian trade with New Zealand is nowof intra-industry type, compared with about 14 per cent in the 1960s. Furthermore,the growth of manufactured exports over the second half of the 1980s (seeSection 3.2 below) has also embodied an increase in intra-industry trade.

3.2 Manufactured Exports

Figure 6 shows growth rates of the main categories of exports. Manufacturedexport volumes5 have grown by almost 15 per cent per annum over the past sixyears, compared with about 6 per cent over the previous six years (see Figure 6).

5. Throughout the paper, manufactures are defined in a narrow sense to exclude some large,simply-transformed categories such as iron and steel and aluminium. These are classified asresource-based exports.

Table 2: Australian Intra-Industry Trade

(as a percentage of total trade)

Period average Total Goods Manufactures

1965-69 5.1 6.2

1970-79 6.6 9.2

1980-85 8.2 9.8

1986-91 11.4 13.4

1991 13.8 17.4

Sources: Lowe (1990) and Australian Bureau of Statistics.


Figure 6: Composition of Exports(1989/90 prices)

0

3

6

9

12

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6

8 Resource-based

Rural

Manufactures

Average annualgrowth rates

Resource- based

Rural

Manufactures

1993

Services

Services

199119891987 199219901988

$B %

6. Reserve Bank of Australia (1992).

While this strong growth has been from a low base, it is symptomatic of importantstructural change occurring in the domestic economy. Some commentators havesuggested that the growth reflects temporary rather than structural factors, arguingthat the growth:

• is cyclical, reflecting sluggish domestic demand;

• is due to fast growth in a few markets and does not reflect a broader strength;and

• is all in categories which are receiving government assistance.

These explanations play some part in the story: in general, however, previouswork has concluded that the growth appears to be too widespread across destinationsand sectors to be attributable principally to the above factors.6 More deep-seatedstructural forces seem to be at work.

3.3 Direction of Exports

There has been a substantial change in the direction of Australian exports overthe past 40 years (see Table 3). In the 1980s, Asia (excluding Japan) became a veryimportant destination for Australian exports, particularly exports of manufactures.


The re-orientation away from Europe and towards Asia was initially driven bythe formation of the EEC and the strong post-war growth of Japan. More recently,the strong growth in Asian countries other than Japan has presented Australia withfurther export opportunities. This group now accounts for one-third of Australia’smerchandise exports (compared with less than 10 per cent in the 1950s and20 per cent as recently as 1980/81). Taken together with Japan and New Zealand,our regional trading partners now account for nearly two-thirds of our merchandiseexports.

The economic growth of this ‘Other Asia’ area has been quite fast for the pastcouple of decades (about 6 per cent per year in the 1970s and 7 per cent in the1980s), but it was not until the 1980s that the region’s absolute size becamesignificant. These countries have not only grown fast, but this has been outward-looking growth, with large increases in the proportion of GDP accounted for byinternational trade (see Table 4). The growing market in these countries can beseen in Figure 7, which compares GDP growth in OECD countries with that inAustralia’s trading partners, where the fast-growing Asian area has provided arapidly growing export market. Unlike the earlier expansion in Japanese demand,the more recent expansion in Australian exports to this region has been focusedon manufactured goods. Simply keeping pace with the growth of manufacturedimports by this region, for example, has resulted in average annual growth in

Table 3: Direction of Merchandise Exports

(per cent of total)

1950s 1970s 1980/81 1991/92

United Kingdom 32.3 5.5 3.7 3.5

Other EEC 21.5 10.4 8.7 9.0

Japan 10.3 30.0 27.3 26.5

Other Asia 9.7 17.1 20.4 32.7

North America 9.7 13.2 13.5 11.0

New Zealand 4.8 5.1 4.8 5.1

Other 11.7 18.7 21.6 12.2

100.00 100.00 100.00 100.00

Notes: (a) Other Asia - Bangladesh, Brunei, China, Hong Kong, India, Indonesia, Cambodia, Korea,Laos, Macau, Maldives, Burma, Pakistan, Philippines, Singapore, Sri Lanka, Taiwan,Thailand, Vietnam.

(b) North America - Canada, United States.Source: Australian Bureau of Statistics Catalogue No. 5436.0.


Table 4: Selected Asian Economies: Exports/GDP(per cent)

1965 1990

China 4 18

Indonesia 5 26

Philippines 17 28

Thailand 16 38

Malaysia 42 79

Korea, Rep. 9 32

Singapore 123 190

Hong Kong 71 137

Source: World Bank, World Development Report 1992.

Figure 7: Output Growth(year-ended percentage change)

-2

0

2

4

6

-2

0

2

4

6

% %

Australia's trading partners

OECD

19931984 1990198719811972 19781975

Australian manufactured exports to Asia of over 20 per cent in the second half ofthe 1980s.

Table 5 shows growth in Australian manufactured exports to various countriesand growth in manufactured imports by those same countries over the second halfof the 1980s.


The data show that although there has been some gain in market share in Asia,there have been even more substantial gains for Australian manufacturers in themore ‘traditional’ markets of New Zealand, OECD Europe and North America.Furthermore, manufactured exports to Asia grew at about the same rate as exportsto the other markets, even though the Asian markets were growing much morequickly. Figure 8 shows that after a long period of declining market share in Asia,Australian manufacturers have managed to hold market share since 1986, and

Table 5: Growth in Manufactured Exports

Country/region Australian Manufactured Share ofmanufactured imports of Australian

exports these countries manufactured(average annual percentage change, exports

1986-1991) (per cent, 1991/92)

Singapore 31.0 24.7 6.1

Hong Kong 21.4 24.9 5.7

Indonesia 38.8 17.8 3.6

Korea 40.0 20.5 2.6

Taiwan 28.0 27.9 2.5

Malaysia 29.1 29.8 2.3

Thailand 35.0 34.1 2.2

Philippines 33.6 22.6 1.2

China -1.8 7.6 1.0

Total Asia (excluding Japan) 27.6 21.4 24.6

Japan 30.2 21.1 7.9

New Zealand 17.7 7.0 18.8

OECD Europe 24.5 14.8 16.3

North America 27.6 6.3 16.0

TOTAL of above 24.8 13.5 83.6

Notes: (a) Due to data limitations, the statistics in this table are in value rather than volume terms.(b) To account for differences in inflation rates among countries, growth rates are measured in

US dollar terms. Details of the calculations are available on request.

Sources: OECD, Foreign Trade by Commodities.Asian Development Bank, Key Indicators of Developing Asia and Pacific Countries.United Nations, International Trade Yearbook.Department of Foreign Affairs and Trade, Central Statistics Section.Council for Economic Planning and Development, Republic of China, Taiwan Statistical DataBook 1992.


Figure 8: Australian Manufactured Exports to Asia(a)

(share of region’s manufactured imports)

7. An excess demand shock of the type described in Section 2 equal to, say, 1 per cent of GDP,which entirely ‘spilled’ into imports would, in an economy with an import ratio of 20 per cent,imply an income elasticity of 5.

0.4

0.6

0.8

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1981 1983 1985 1987 1989 1991

% %

197919771975

Manufactured exports

Note: (a) As defined in Table 5, but excluding China and Taiwan.

perhaps even increase it slightly. Some of these puzzles will be examined in theempirical work of the next section.

4. Estimating Trade Equations

So far, in looking at the short-term movements and structural changes, theanalysis has been descriptive. The next two sections attempt to bring a degree ofprecision to the analysis, with econometric estimates of imports and exports. Thediscussion above suggests a number of possible explanators:

• relative prices;

• reductions in tariffs and other assistance; and

• strong growth in Asia.

4.1 Imports

In Section 3, the rise in the ratio of imports to GDP was noted as an example ofstructural change. High short-term income elasticities make some intuitive sense.7

But in the longer term, elasticities closer to unity might be expected, so the sharp


rise in the imports/GDP ratio suggests that structural factors are at work. Thissection explores this through the estimation of an import equation.

A recent study by Wilkinson (1992) is taken as the starting point. This used anerror-correction approach to estimation which seems particularly suited to tryingto separate short-run and long-run elasticities. The results of this work differedsomewhat from those of previous studies.8 Estimates of the long-run incomeelasticity were much higher - in a range of 1.85 to 1.94 depending on the definitionof imports and the activity variable used. At the same time, the estimates of priceelasticities were generally lower than in previous studies: -0.3 to -0.8. Wilkinson’spreferred equation succeeded in tracking, out of sample, the large rise in importsin 1988/89 and the subsequent fall.

One surprising characteristic of the Wilkinson equation is that there was nosubstantial difference between short and long-run income elasticities, even thoughthe estimating technique had the potential to separate these. The relatively highincome elasticities estimated make some sense for the short-run response toincome shocks, but it is hard to see why the long-term elasticities should be so high.Five possible reasons could be put forward:

• computer imports became such an important component, and grew soquickly, that they need to be explained not only by income and relative priceelasticities but also in terms of changing tastes in technology;9

• imports comprise capital goods, consumption goods and intermediate inputs(with the last category accounting for about half of endogenous imports).There may be too much diversity in the behavioural relationships underlyingthe various groups of imports to be able to model them successfully inaggregate;

• other structural changes, particularly on the domestic supply side, have beenimportant and are being confounded with the income elasticities of thedemand equation;

8. See Macfarlane (1979) for a survey of price and income elasticities of demand for imports fromthe 1960s and 1970s. Gordon (1986) reports price elasticities for a few studies in the 1980s.

9. When rebasing the constant price estimates to 1984/85 prices (in 1988), the Australian Bureauof Statistics (ABS) introduced a new method for calculating the volume of computers. Theynow use a computer price series, developed by the Bureau of Economic Analysis (BEA) in theUnited States, to deflate the value of computer imports. Due to the rapidly improving qualityof computers over time, this price series falls almost continuously and very sharply, and thevolume correspondingly rises very sharply. (See McCarthy (1989) for details of this methodof calculation.) As a result, estimation of import demand functions which include computerswill tend to find much larger elasticities on income and relative price than if computer importshad been excluded. Studies carried out prior to the introduction of this computer price seriesby the ABS (i.e. all of the studies reported in Macfarlane (1979)) will not be affected by thisproblem.


• the reduction of protection represents an important structural change whichis not captured in the Wilkinson equation, but which might be expected toexplain an important part of the increase in imports (and exports) as a per centof GDP. The regression may be attributing to the income variable some of theinfluence of tariff reductions; and

• as a result of greater international integration, greater intra-industry trade mayexplain higher imports and exports, for any set of income and prices.

The final three relate to structural supply-side changes which are poorly definedin the sort of model estimated here. The final two were discussed in Section 3 asreasons why gross trade flows may be rising in general.

The following sections look briefly at the first two issues. A third section looksat whether reductions in protection help to explain the rise in import volumes.Intra-industry trade was discussed in Section 3 and will not be covered again here.

4.1.1 Excluding computers

Table 6 compares Wilkinson’s results with a re-estimation of the same modelexcluding computers.10 This gives some idea of the extent to which computerimports have influenced the relevant elasticities. Rebasing the constant priceestimates resulted in a much lower growth in endogenous imports11 and estimatingWilkinson’s model using these rebased data and a longer sample, results in a

10. The model is estimated over a longer sample than Wilkinson’s; September 1974 toDecember 1992. Furthermore, it is a simpler model. In particular, it excludes the relative priceof exports and capacity constraints which, in subsequent work, were found to be insignificantin the long-run equation estimated using the Phillips-Hansen technique.

11. See Australian Bureau of Statistics Catalogue Nos 5227.0 and 5243.0.

Table 6: Long-Run Elasticities of Import Demand

Income Relative Price

Wilkinson (1992) (1984/85 prices)1974:3 to 1989:3 1.94 -0.49

This study (1989/90 prices)1974:3 to 1992:4

including computers 1.70 -0.45(33.55) (-4.43)

excluding computers 1.55 -0.42(28.55) (-3.36)

Notes: t statistics are in brackets. There were no t statistics reported in Wilkinson.


12. The reason for this difference is not the sample period. When the model was estimated usingthe rebased data including computers over the same period as Wilkinson (1992) the incomeand price elasticities were 1.72 and -0.49, respectively.

significantly lower income elasticity.12 The effect of excluding computers hasbeen to reduce the income elasticity further, as would have been expected. Whilemuch lower, however, the income elasticity is still well above unity.

4.1.2 Disaggregation

Consumption goods might be expected to have a higher price elasticity than,say, investment goods, because there are close domestic substitutes for consumptionimports. Producer inputs may be less responsive to changes in relative prices.Figure 9 shows growth of each type of import with a relevant activity variable andrelative price. Long-run equations and error-correction models were estimated foreach component of imports. Table 7 summarises the long-run elasticities. Detailsof the estimates are recorded in Appendix A.

Two main conclusions emerge. Firstly, for all three categories of imports,income elasticities are significantly greater than 1 (but below the Wilkinsonestimate). Consumption imports appear to have a higher income elasticity thanother types of imports. The high aggregate income elasticity, however, does notappear to be the result of behavioural differences in imports; whatever is pushingup the income elasticities is a general factor, affecting all types of imports.Secondly, there are substantial variations in price elasticities. Consumption andcapital imports have price elasticities around -0.8, higher than for total imports.The relative price effect on ‘other’ imports (principally intermediate goods) is

Table 7: Long-Run Elasticities of Import Demand

Component of Imports Income RelativePrice

Consumption 1.73 -0.70

(17.76) (-5.15)

Capital (using GNE) 1.40 -0.76

(5.48) (-2.29)

Other 1.48 -0.18

(12.01) (-1.53)

Note: t statistics are in brackets.


Figure 9: Imports, Activity and Relative Prices(year-ended percentage change)

-15

0

15

30

-15

0

15

30

-15

0

15

30

-15

0

15

30

-15

0

15

30

-15

0

15

30

Consumption imports

Relative prices

Consumption

Capital imports

Relative prices Investmentin plant &

equipment

Other imports

GDP(non-farm)

1984

% %

% %

% %

much smaller at -0.2 and is statistically insignificant at the 10 per cent level. Thismakes some intuitive sense; there may well be limited domestic substitutes forimported inputs and producers may find it easier to pass these costs on.


4.1.3 Tariffs

With falling protection, the price of imports facing consumers will be fallingrelative to the price of domestic goods and the import penetration ratio willtherefore be rising. The price of imports over the docks does not capture this effectso the relative price term in the import equations was adjusted to allow for fallingtariffs.13 The adjustments were made in both the aggregate equation and in theequation for consumption imports, reflecting an a priori belief that protection ismost prevalent on consumption items.

Table 8 reports the results of this further estimation, comparing it with earlierestimates. Evidence of a tariff effect is very weak; the differences in the estimatesare not statistically significant. Nevertheless, it is interesting to note that theincome elasticity, in particular, moves in the expected direction; it falls when thetariff adjustment is included.

13. See Appendix A for a description of this adjustment.

Table 8: Long-Run Elasticities

Activity Relative Price

Endogenous Imports:without tariff adjustment 1.55 -0.42

(28.55) (-3.36)

with tariff adjustment 1.50 -0.41(24.26) (-3.52)

Consumption Imports:without tariff adjustment 1.73 -0.70

(17.76) (-5.15)

with tariff adjustment 1.64 -0.68(16.11) (-5.03)

Note: t statistics are in brackets.

The evidence from Table 8 is not particularly compelling. An alternative modelwas therefore formulated to further test the importance of falling protection inimport growth. The dependent variable was defined to be the import penetrationratio (endogenous imports/GDP) - i.e. the coefficient on domestic income wasconstrained to be unity. Two variables were tried to capture the tariff effect. Firstly,the effective rate of assistance (ERA, as shown in Figure 5) was used as anexplanator, together with the relative price series used in the regression reported


14. See Appendix A for details.

in Table 6 (RP1, it does not incorporate tariffs). The results are reported in Table 9.Secondly, a relative price which incorporates import prices measured at the retaillevel (i.e. including tariffs) was tried (RP2).14 This variable is available only sinceDecember 1984, so the sample period is reduced to 32 observations. Theperformance of this relative price was then compared with the performance of therelative price term which does not incorporate tariffs.

The first regression indicates a significant relative price elasticity of around -0.7and an elasticity on ERA of around -1.2, although this variable is not significantat the 10 per cent level. The second and third regressions show the results with thetwo different relative price variables. These tests should be interpreted cautiously.The sample period for these regressions is very short and the long-run coefficientsreported may be biased (Inder 1991). For what it is worth, both relative pricevariables have significant long-run coefficients. The fourth column presents asimple test of the relative performance of each variable. The results suggest thatRP2, the relative price including tariffs, performs better in modelling the importpenetration ratio.

A lot of weight should not be given to these results. Nevertheless, takentogether, the results in Tables 8 and 9 are weak evidence of a role for tariffreductions in explaining the rise in imports. These results will be used in Section 5in discussing structural change.

Table 9: Tests of the Effect of Tariffs

Endogenous imports/GDP Period of Long-runregressed on: Estimation Coefficient F test (b)

(i) ERA 74:3 - 92:4 -1.16(-1.13)

RP1 -0.65(-2.47)

(ii) RP1 84:4 - 92:4 -0.65 F(8,20) = 2.174(-4.83) (0.076)

(iii) RP2 84:4 - 92:4 -1.06 F(8,20) = 3.978(-3.15) (0.006)

Notes: (a) t statistics are in brackets.(b) F test of the hypothesis that all variables in the error-correction model could be excluded. The

figures in brackets are significance levels.


4.2 Exports

This section explores trade equations for exports, with the special interest beingthe role of the exchange rate and relative prices. Relative prices could find theirway into export equations in three ways:

• export prices/domestic prices: this ‘internal competitiveness’ represents thesupply-side effect, whereby a rise in export prices may attract resources awayfrom other uses, principally in the non-traded sector;

• Australian export prices/world export prices: this reflects the competitivenessof Australian exports, vis-à-vis rival suppliers; and

• export prices/prices in the ‘target’ market: this captures the competitivenessof Australian exports, vis-à-vis alternative sources of supply within theimporting country.

It has proven difficult to find clear relative price effects in export equations forAustralia (although Goldstein and Khan (1985) report some success for othercountries). For the bulk of Australia’s exports (commodities), the supply-orientedrelative prices are probably the most relevant, as there is no scope for pricedifferentiation in this sort of homogenous good. Given the long lags in supplyresponse, it is perhaps not surprising that this relative price effect is difficult to find.

The focus in this paper will be on manufactures, as this is not only thecomponent of exports which has grown extraordinarily quickly since themid-1980s, but it may also be more responsive to demand-oriented relative prices.Such goods are not homogenous; there is scope for product differentiation and,therefore, price differentials between similar goods on the world market.Furthermore, for a small country such as Australia, the price elasticities of demandfor manufactured exports would be expected to be relatively high. With only asmall share of world markets, growth in Australia’s exports of manufacturesshould not be constrained by total market growth; a fall in the relative price ofAustralian manufactures would, therefore, be expected to result in a significantrise in exports of those goods.

4.2.1 Exports of manufactures

This section relates the growth in manufactured exports to a number of variablesincluding relative prices and foreign income. The feature which distinguishes thisstudy from earlier estimates15 is that it uses cross-section as well as time series data.A panel of annual data on Australian manufactured exports to 21 countries from

15. See, for example, Hargreaves, Harrington and Siriwardana (1993), Menzies andHeenan (1993), and Ryder and Beacher (1990). Coppel, Simes and Horn (1988) report theresults from the NIF88 model of the Australian economy.


1976 to 1991 is constructed and used in estimation. There are a number ofadvantages to using panel data in this situation. Firstly, quarterly data on exportsare very volatile. Use of cross-section data allows the time series to be annualwithout immediately running into sample size problems. Secondly, the Asiancountries have grown very quickly over the past decade and have becomeincreasingly important destinations for Australian manufactured exports. Use ofcross-section data allows these differential growth rates to be explicitly accountedfor, and for any differences in income elasticities across countries to be tested.More generally, use of cross-section data introduces more variation to the data,which may assist in identifying the influence of particular factors. Finally, thereare some econometric advantages which are discussed in Appendix B.

A general model of Australian manufactured export volumes is given in thefollowing equation.16

Xit = fi(Yit, Wt, Pit, Ζit) (1)

where Xit is the volume of manufactured exports to country i at time t, Yit is the reallevel of income in country i, Wt is the price of Australian manufactured exportsrelative to world manufactured exports, Pit is the price of Australian manufacturedexports relative to country i’s manufactures, and Ζit is any other variable that mayimpact on the penetration of Australian manufactured exports overseas.

Australian manufactured exports to countryi are, at the simplest level, afunction of the income in countryi and the price of Australian manufacturedexports relative to the price of competitors. Other factors which may be relevantare:

• ‘internal’ competitiveness: if supply is not infinitely elastic, some rise in theprice of exports relative to goods sold domestically will be needed to inducean increase in the supply of exports. This may be a short-term switch (the sameproduct simply being sold in a different market) or a long-term one (re-allocationof productive resources to production of traded goods rather than non-traded).The expected sign of this variable is ambiguous. A decline in the price ofexports relative to other domestic goods may result in a decline in the supplyof exports. On the other hand, the decline in the price of exports may reflecthigher productivity in this sector and a flow of resources into exports. In thiscase, lower export prices relative to domestic prices will be associated witha rise in exports;

• Australian domestic demand: a frequently heard explanation for the stronggrowth in manufactured exports is that producers are exporting simplybecause they cannot sell their products in the domestic market due to domestic

16. See Appendix B for details of data constructions and sources.


recession. The implication is that penetration rises when domestic demand isweak and falls as domestic demand strengthens; and

• reductions in protection: tariffs and other forms of protection have a damagingeffect on Australian exports through resource misallocation and higher inputcosts. Furthermore, they reduce pressure on domestic producers to innovateand improve efficiency, thus reducing their competitiveness in world markets.Therefore, as protection is reduced, exports would be expected to rise.

The approach was to obtain non-structural estimates of the impact of foreignincomes and relative prices on Australian manufactured exports. Other variableswere then added to the basic formulation to see if they add any explanatory powerand/or detract from the explanatory power of the basic variables.17 Initially, tworelative price terms were included; the price of Australian manufactures relativeto world prices (the world relative price) and the price of Australian manufacturesrelative to the domestic price of manufactures in the importing country (bilateralrelative prices). The bilateral relative price did not add significant explanatorypower, so it was dropped from the basic model. The world relative price variablewas significant when the bilateral price was included and did not vary much withits exclusion.

The results of the basic model are shown in the second column of Table 10.Here, the income and price elasticities are constrained to be the same betweencountries of export destination.

The coefficients on world relative prices and foreign GDP were significant andof the expected sign. An increase in the price of Australian manufactured exportsrelative to world prices is associated with a fall in manufactured exports. Althoughthe significance level cannot be calculated from this formulation, the estimatessuggest that the long-run effect of the world relative price on Australianmanufactured exports is around -6.4. That is, over the period of estimation, a1 per cent fall in Australian manufactured export prices relative to world prices isassociated with about a 6.5 per cent rise in the volume of manufactured exports.

An increase in foreign GDP is associated with a rise in Australian manufacturedexports; the constrained estimates from the basic model suggest a long-run‘elasticity’ of 0.8 on foreign GDP, although once again, significance levels cannotbe calculated.

The third to sixth columns of Table 10 show the results of including otherfactors in the basic model, one at a time. Apart from the effective rate of assistance,none of the other factors improved the fit of the model markedly (as measured bythe sum of squared residuals (SSR) and the standard error of estimate (SEE)). The

17. See Appendix B for details.


Tab

le 1

0:S

umm

ary

of R

esul

ts

∆xit =

αi +

β0x

it–1

+ β

1∆x it–

1 +

ω0w

t–1 +

ω1∆w

t + ω

2∆w

t–1

+ η

0yit–

1 +

η1∆

y it +

η2∆

y it–1

+ ξ

0zit–

1 +

ξ 1∆z it

–1+

ξ 2∆z it–

1 +

εit

Mod

elB

asic

Dom

estic

Aus

tral

ian

Cap

acity

Effe

ctiv

eM

odel

Rel

ativ

eG

NE

Util

isat

ion

Rat

e of

Pric

esA

ssis

tanc

e

Exp

orts

–0.2

5–0

.24

–0.2

8–0

.27

–0.3

1x it–

1(0

.07,

0.0

0)(0

.08,

0.0

0)(0

.07,

0.0

0)(0

.07,

0.0

0)(0

.07,

0.0

0)

∆xit–

10.

350.

400.

370.

500.

28(0

.18,

0.0

5)(0

.22,

0.0

7)(0

.18,

0.0

4)(0

.22,

0.0

2)(0

.18,

0.1

3)

Wor

ld r

elat

ive

pric

es–1

.60

–2.2

0–1

.96

–2.2

1–1

.54

wt–

1(0

.55,

0.0

0)(0

.61,

0.0

0)(0

.97,

0.0

4)(1

.02,

0.0

3)(0

.58,

0.0

1)

∆wt

–1.3

7–1

.73

–2.0

0–3

.33

–1.4

0(0

.51,

0.0

1)(0

.57,

0.0

0)(1

.08,

0.0

6)(0

.84,

0.0

0)(0

.60,

0.0

2)

∆wt–

10.

761.

291.

581.

880.

60(0

.47,

0.1

0)(0

.57,

0.0

2)(0

.98,

0.1

1)(0

.74,

0.1

1)(0

.42,

0.1

6)

Long

-run

ela

stic

ity–6

.36

–9.0

5–7

.00

–8.0

9–5

.00

Join

t sig

nific

ance

11.8

13.8

34.

3421

.18.

65(0

.01)

(0.0

0)(0

.23)

(0.0

0)(0

.03)

Impo

rtin

g co

untr

y G

DP

0.20

0.11

0.10

0.01

0.19

y it–1

(0.1

2, 0

.08)

(0.1

5, 0

.47)

(0.1

3, 0

.45)

(0.1

4, 0

.95)

(0.1

2, 0

.10)


∆yit

1.78

1.77

1.87

1.85

2.12

(0.9

4, 0

.06)

(1.0

1, 0

.08)

(0.9

7, 0

.05)

(0.9

1, 0

.04)

(0.9

6, 0

.03)

∆yit–

10.

171.

290.

280.

010.

31(1

.04,

0.8

7)(0

.57,

0.0

2)(0

.99,

0.7

8)(1

.03,

0.9

9)(0

.88,

0.7

2)

Long

-run

ela

stic

ity0.

800.

450.

360.

030.

61

Join

t sig

nific

ance

6.63

4.90

6.57

6.56

8.24

(0.0

8)(0

.18)

(0.0

9)(0

.09)

(0.0

3)

Add

ed v

aria

ble

—–0

.36

0.14

0.25

–1.0

7z it–

1(0

.40,

0.3

7)(0

.30,

0.6

5)(0

.29,

0.4

0)(0

.25,

0.0

0)

∆zit

—0.

83–0

.95

0.33

–0.3

5(0

.74,

0.2

6)(0

.83,

0.2

5)(0

.19,

0.0

9)(0

.50,

0.4

9)

∆zit–

1—

0.15

–1.8

5–0

.68

1.26

(0.6

6, 0

.82)

(1.2

6, 0

.14)

(0.3

2, 0

.03)

(0.6

6, 0

.06)

Long

-run

ela

stic

ity—

–1.4

70.

490.

90–3

.46

Join

t sig

nific

ance

—3.

419.

4920

.75

18.6

2(0

.33)

(0.0

2)(0

.00)

(0.0

0)

R2

0.15

0.11

0.16

0.10

0.27

SS

R31

.60

33.2

031

.20

33.5

027

.20

SE

E0.

330.

340.

330.

340.

31

Not

es:

(a)

For

coe

ffici

ent e

stim

ates

, the

num

bers

in p

aren

thes

es a

re, f

irstly

, the

sta

ndar

d er

ror

of th

e co

effic

ient

est

imat

e an

d, s

econ

dly,

the

sign

ifica

nce

leve

l.(b

)A

ll st

anda

rd e

rror

s ar

e N

ewey

-Wes

t cor

rect

ed fo

r he

tero

sced

astic

ity a

nd s

eria

l cor

rela

tion.

(c)

Join

t tes

ts o

f sig

nific

ance

are

Wal

d te

sts

dist

ribut

ed a

s χ2

(3)

and

figur

es in

par

enth

eses

indi

cate

the

sign

ifica

nce

leve

l.


Phi

lippi

nes

Tha

iland

Sin

gapo

re

Chi

na

Mal

aysi

a

Indi

a

Hon

g K

ong

Tai

wan

Indo

nesi

a

Sou

th K

orea

Sw

eden

Net

herla

nds

Uni

ted

Kin

gdom

Japa

n

Can

ada

New

Zea

land

Fra

nce

Italy

Uni

ted

Sta

tes

Sw

itzer

land

G

-2

-1

0

1

2

3

4

5Asia Other

Average = 0.4

Average = 1.9

domestic relative price terms were jointly insignificant. Both Australian GNE anddomestic capacity utilisation were jointly significant when added to the basicmodel but improved the fit only marginally. In both cases, there is a negative effectin the short run. The implied long-run effects, however, are positive, probablycapturing the relationship between output and exports; over the long run, outputand exports will tend to rise together.

The inclusion of the effective rate of assistance in the model improved the fitmarkedly. The coefficients were jointly significant and the implied long-run‘elasticity’ of the expected sign. It also reduced the income and price elasticities.The estimates show that the fall in assistance over the past decade helps to explainthe growth of manufactured exports over this period. This is discussed in moredetail below.

Importantly, the addition of extra variables did not greatly change the conclusionon relative prices. Even when the effective rate of assistance is included, theimplied long-run ‘elasticity’ on the relative price is still high at 5. On the otherhand, the effect of foreign-country GDP on Australian manufactured exportsseems more unstable with the addition of further variables.

One advantage of panel data is that it is possible to test the hypothesis that theincome elasticities for individual countries are equal. Figure 10 shows the resultsof estimating the basic model with protection while allowing income elasticitiesto vary across countries. It shows the implied long-run elasticities for all countries,divided into two groups - Asia and all others.18 The horizontal lines represent the

18. Japan is not included in Asia as it is an industrialised country and a long-standing tradingpartner of Australia.

Figure 10: Income Elasticities of Australian Manufactured Exports


average for each group. The difference between the two groups is marked. Ingeneral, income elasticities for the Asian countries tend to be much lower than forthe other countries included in the estimation. The average income elasticity forthe 10 Asian countries is 0.4, compared with an average elasticity of 2 for theother 11 countries. A test of the hypothesis that coefficients on income could beconstrained to be equal across countries was conclusively rejected. This result isdiscussed more fully in Section 5. Once again, this variation on the basic modeldoes not detract from the significance of either the relative price variable or theeffective rate of assistance. The implied long-run elasticity on the relative priceremains around 5 and that on the rate of assistance around 3.5.

The next section interprets these findings in the context of long-term structuraladjustment and the stylised facts outlined in Section 3.

5. Structural Change: What Has Been Achieved?

This section brings together the descriptive material from Section 3 and theeconometrics from Section 4 to assess how the process of structural change (asopposed to the cyclical behaviour examined in Section 2) is proceeding. Theadaptability of the trade balance is of particular interest: are the changes whichwere noted in Section 3 simply ‘one-off’ accidents, or is there a process ofadjustment underway which will improve our adaptability and flexibility? Inparticular, what is the role of the exchange rate and relative prices?

Two factors were at the heart of the adjustment process: the substantial cut inindustry protection since 1984; and a real exchange rate that has been, on average,13 per cent lower since 1986 than it was in the previous decade.

The structural adjustment of the real exchange rate reflected three influences.Firstly, the foreign debt build-up, identified by Blundell-Wignallet al. as aninfluence on the exchange rate (in this Volume). The real exchange rate needed todepreciate in a trend sense so that a more positive trade balance would offset thepermanent increase in net income payments to the rest of the world.

Secondly, the exchange rate responded to commodity price movements,smoothing the Australian dollar ($A) prices of commodities. In the mid-1980s, theexchange rate changed to offset cyclical movements in world commodity prices.Also, the secular weakness in commodity prices lowered the exchange rate in thelonger term. So the exchange rate has not only reduced fluctuations in the returnto exporters, but has probably left a longer-term effect. The story is morecomplicated for non-resource exporters. As the exchange rate buffers the $Aprices received by commodity exporters, this imposes a counterpart pattern on thereceipts of other exporters. This has resulted in more volatility within thecommodity price cycle and some enhancement of international competitivenessof manufactures in the longer term. In practice, Australian exporters of


manufactures seem to have held their export prices in Australian dollars fairlysteady in the face of exchange rate fluctuations: Australian manufacturing exportprices relative to their rival foreign suppliers’ prices improve, more or lesspari passu, when the exchange rate depreciates (see Figure 11). This behaviour isalso clear in the work on export price pass-through by Dwyer, Kent and Pease(1993). In the first instance, exporters pass on the benefits of a more favourableexchange rate to their buyers, thus enhancing their international competitiveness.This behaviour means that commodity price fluctuations may provide exportersof manufactures with the opportunity to make their products very competitive ininternational markets. It also fits with the idea of ‘beachheads’ (see below), andwith the general picture which is emerging - that the events of the mid-1980swere very important in triggering off structural change within the balance ofpayments.

Thirdly, the exchange rate had to adjust downwards with the opening up of theeconomy through reductions in effective rates of assistance. While there aredynamic gains for exports, greater openness influences imports even moredirectly. It is likely that the very large income elasticity identified in the importequations reflects reductions in assistance that could not be captured by the simpleadjustments to prices used in the econometric estimation. Tariff reductions, otherthings being given, would cause the trade balance to deteriorate. For longer-run

80

90

100

110

120

80

90

100

110

120

Real TWI

Relative price ofmanufactured exports

1974 1988 199219861984 1990

Index Index

198019781976 1982

Figure 11: Manufactured Export Prices and Real TWI(1985 = 100)


balance of payments equilibrium, the real exchange rate would have to fall.19

When these views are placed alongside the estimated relative price elasticities ofimports and manufacturing exports, the reason why both of these variables haverisen as a share of GDP comes more clearly into perspective. While opening upthe economy encouraged both exports and imports, the effect was greater onimports, which explains their rise. The trend fall in the exchange rate had a muchgreater impact on increases in exports (or at least on the manufacturing component,which contributed one-quarter of export growth over the past six years) than it didon reducing imports.

The impact of reduced protection was most clearly identified, in an econometricsense, on the export side. The average effective rate of assistance from 1986 to1991 was 15 per cent lower than over the previous 10 years. With an elasticity of-3.5, this accounts for a rise in manufactured exports of a bit over 50 per cent.Therefore, of a total rise in manufactured exports of around 130 per cent over thisperiod, this variable accounts for around 40 per cent. In principle, the effect oftariff reductions on exporters’ costs would be expected to be picked up in therelative price term. The explicit tariff variable may, therefore, be picking up thedynamic aspects of opening up the manufacturing sector to competitive pressures.These dynamic supply-side effects (discussed in general terms by Edwards (1989)and Krugman (1989a)) are difficult to identify more precisely than with thesecrude elasticities, but there is little doubt that such changes are underway. Theyshow clearly in, for example, the rapid rise of intra-industry trade. Over time theywill make firms more efficient or will cause resources to move from less efficientto more efficient sectors.

However, 80 percentage points of the 130 per cent rise in manufactured exportsis explained by other factors. Improved competitiveness over the past seven years(via a lower real exchange rate) is, according to the econometric estimates, themain reason for the fast growth. With a price elasticity of around 5, this accountsfor around half of the 130 per cent increase in export volume growth since1985/86.

Other evidence also suggests the importance of this sharp change in theexchange rate during the mid-1980s. Menzies and Heenan (1993) presentedeconometric evidence that there is some threshold relative price change which willtrigger firms to enter export markets. Once ‘beachheads’ are established, the sunkcosts of entering foreign markets mean that firms will continue to export, even

19. The longer-run outcome may be more complicated. If the dynamic efficiency gains that comewith tariff reductions are significant (which they may well be in the long run), the productivityincreases for the tradeable goods sector that come from this will appreciate the real exchangerate.


when relative prices move less favourably (as they did in 1988 and 1989, seeFigure 11). Furthermore, survey evidence reported in the paper showed that for arelatively large number of firms, exports first became a significant part of sales in1986 (see Figure 12) and that 60 per cent of firms cited the exchange rate as animportant factor in their decision to commence exporting.20

The price elasticity is much higher than other studies of Australian manufacturedexports have estimated.21 Although theory would suggest a relatively highelasticity, the actual estimate may be capturing other effects as well. In particular,there seems to have been a change in attitude towards exporting in recent years,particularly to the Asian region. McKinsey & Company (1993, p. 37) attributethis change in export culture to both a ‘stick’ and a ‘carrot’. The ‘stick’ is ‘therelentless internationalisation of the Australian economy and the growingcompetition that our Asian neighbours are providing in domestic markets’. The‘carrot’ is a combination of perceived government support for exporting (bothpsychological and financial), peer pressure and media attention. If the change in

20. For the purposes of the survey, exports were defined as ‘significant’ when they exceeded10 per cent of sales. This result is broadly consistent with the results of a study by McKinsey& Company (1993) which was based on a much larger sample.

21. The studies listed in Footnote 15, for example, estimated price elasticities in the range -0.7 to-1.5.

Figure 12: First Year when Exports Exceeded 10 per cent of Sales

0

5

10

15

20

25

0

5

10

15

20

25

% of firms

54 55 62 67 74 79 82 85 86 87 88 89 91

1950s 1960s 1970s 1980s & 90s


‘culture’ occurred simultaneously with the sharp change in the exchange rate inthe mid-1980s and the fall in tariffs, it may be difficult to separate these effects.This is not to say that the change in culture occurred independently of relativeprices: the increased competitiveness may well have been the catalyst forattitudinal changes. Once this started, demonstration effects and other lesstangible factors probably played an important role in keeping the process going,even without any further improvements in competitiveness.22 So the relative priceterm (with its seemingly high elasticity) may well be capturing a range ofinterrelated changes that are unique to the estimation period. We would not wantto interpret it as a simple price elasticity, with the implication that a smallimprovement in competitiveness will always bring about a large increase in exportvolumes.

The income elasticities of these equations, too, will pick up a variety of factors.They incorporate rising import penetration in the importing country, but will alsocapture compositional effects reflecting the changing mix of the recipient country’simports and the interaction of this with Australia’s export supply capabilities. Sothe interpretation of these elasticities is not straightforward. Nevertheless, sometentative conclusions can be made, in answer to the question: ‘How dependent wasthe growth of Australian manufactured exports on the ‘tailwind’ from the rapidgrowth of Asian economies?’ Income in the Asian countries has been growingmuch more quickly than elsewhere, but the income elasticities for these countriesare, on average, much lower - often less than unity (see Figure 10). Strong growthin this region has therefore been helpful but, by itself, is not enough to explain theexceptional performance of Australian manufactured exports.

At face value, this suggests that without continual improvements incompetitiveness, exports of Australian manufactures to Asia will not keep pacewith their growth. One possible reason for this result is the priority given in Asianeconomies to developing their own manufacturing sectors. This would implyrelatively low income elasticities of demand for manufactured imports by thosecountries. Asian imports of manufactures have, however, grown very stronglyover the past two decades: at the same time, Australian exporters have lost marketshare (see Figure 8).

An alternative possible explanation is related to the composition of Australianmanufactured exports and the pattern of development of the Asian economies. Itmay be that these countries were encouraging (with tariffs and other types ofassistance) the very industries which Australia, with its history of tariff protection,had encouraged, so their imports were a poor ‘fit’ with our supply capabilities.

22. One such effect, cited by Menzies and Heenan (1993), is the ‘vanguard’ effect; exportersentering new markets make it easier for others to follow.


Their imports were, perhaps, concentrated on manufactures which we wereill-equipped to supply. It was only the increased competitiveness in 1985/86 thatstopped the slide in market share.

This might suggest that these low income elasticities were a reflection of theestimation period, and that structural change in Australia may raise the relevantelasticities. As protection for Australian manufacturing has declined, resourceshave moved into different areas and the character of the domestic manufacturingbase has changed. McKinsey & Company (1993) highlight the rise of the ‘smallto medium-sized, high value-added manufacturers’, exporting to niche markets inwhich quality and service are important. As these types of exporters continue toincrease in importance, the income elasticity of demand for Australian manufacturedexports to Asia is likely to rise.

Table 11 summarises the influence of the various factors discussed above.

23. As discussed by Corden (1968).

6. Conclusion: the Adjustment Process

Concerns about the external sector have been longstanding, with an overlay of‘brooding pessimism’.23 The concerns were threefold:

• Australia’s heavy dependence on commodity exports meant that internationalfluctuations buffeted the economy. To the extent that exchange rate changesbuffered commodity export producers in the face of changing world prices,this delivered increased volatility to non-commodity exporters - notably,manufacturers. With this went a concern that commodity prices were on along-term secular downward trend, and this would constrain our incomes andour export earnings;

Table 11: Growth in Manufactured Exports: 1986-1991

Elasticity Change in variable Contribution to growth(percentage points) (percentage points)

Protection -3.5 -15 53Relative prices -5 -13 65Income(a) 21

Total 139

Actual growth in manufactured exports 130

Note: (a) Calculated using actual income growth with estimated income elasticities for each country.


• Australia seemed particularly subject to ‘elasticity pessimism’ - importincome elasticities higher than export elasticities, combined with priceelasticities which were small, so that depreciations did little to improve thetrade balance. To this was added the apparently adverse ‘J curve’ effect -valuation effects made the current account look worse (in $A terms) followinga depreciation; and

• there was a feeling that dependence on substantial foreign capital inflowmade Australia vulnerable.

These concerns and pessimism did not disappear with the floating of thecurrency. The float and the greatly increased integration with world capitalmarkets did, however, change thinking about the nature of the external constraint.No longer was it seen in terms of excessive current account deficits threatening toexhaust official foreign exchange reserves within a fixed exchange rate framework.There was an increasing recognition that the central issue was the readiness offoreigners to take on Australian assets, and Australians to take on foreignliabilities, and that the focus should be on the sustainability of Australia’s foreignliabilities. As these liabilities rose (see Figure 13), they became the centre ofvigorous debate, some of which spilt over from time to time into the foreignexchange market. Some saw the likelihood of a ‘hard landing’, along the linespredicted by Marris (1985) for the United States. Others have had the moresanguine view embodied in Stein’s law - ‘if something cannot go on forever, it willstop’ - and its corollary - ‘if something cannot go on forever, and everyone knowsthat it cannot go on forever, it will slow down and stop before it reaches the pointbeyond which it cannot go on’ (Stein 1991, p. 262).

The discussion in Section 5 suggests that adjustment is underway: but is itenough or is the ‘brooding pessimism’ still justified? As the analytical timehorizon lengthens, the considerations of foreign debt build-up and the fundingaspects of the external balance become central. The enlarged current accountdeficit in the 1980s led to an accumulation of foreign debt which, in time, shouldinduce adjustments in the trade balance. Figure 13 shows the relative importanceof foreign liabilities, by (notionally) netting these against the capital stock. Part ofthe adjustment occurs through the influence of income and wealth on spending:in this, issues such as the productivity of investment become important. If the debtallowed an increase in effective productive capacity, the higher domestic incomeprovides the wherewithal to service the debt. If the savings-investment imbalancereflected increased consumption or unproductive investment, the adjustmentcomes about via a lower national income and decrease in domestic wealth overtime. As the savings-investment balance changes, counterpart changes occur inthe current account, and the exchange rate is an element in this adjustment.

The structural adjustments examined in the previous three sections not only


0

100

200

300

400

500

600

700

0

100

200

300

400

500

600

700

Net foreign liabilities

Net capital stock

$B $B

79/80 85/8683/8481/82 89/90 91/9287/88

Capital stock lessliabilities

Figure 13: Capital Stock and Foreign Liabilities

increased exports and imports, but brought an improvement in the overall tradebalance. The cyclical behaviour of activity and commodity prices make theunderlying improvement difficult to measure with precision, but Figure 14suggests that the goods and services balance has improved by about 1.5 per centof GDP over the 1980s. This, if it continues, is consistent with the proposition thatAustralia’s longer-run balance of payments is adjusting according to therequirements of longer-run sustainability.24 The adjustment in the trade balancehas allowed the underlying current account deficit to remain steady in the face ofa build-up in foreign income debits. Sustainability - in one sense - is beingachieved. With a constant current account deficit, foreign liabilities willasymptotically rise over time towards a fixed ratio of foreign liabilities to GDP.

The central issue, however, is whether this adjustment process is a smooth one,or might involve discontinuities coming from shifts in sentiment. Sustainabilityis ultimately defined by participants in foreign capital markets and their view maychange over time. Those who worry about this see the demand for foreignliabilities as a behavioural relationship that can shift markedly in response tochanges of sentiment. The exchange rate elasticity of the demand for foreignliabilities is important also. If there is a widely held, stable view of where theequilibrium exchange rate should be, then a small fall in the exchange rate is

24. See, for example, Whitelaw and Howe (1992).


Figure 14: Balance of Goods and Services and Real TWI

50

60

70

80

90

100

110

120

-5

-4

-3

-2

-1

0

1

2

Index

Real TWI(LHS)

Balance of goodsand services (RHS)

1981 1983 1985 1987 1989 1991 1993

Average real TWI79/80 to 84/85

Average real TWI85/86 to 92/93

% of GDP

1977 19791975

enough to encourage capital inflow. If, on the other hand, the equilibrium rate isnot well defined and ‘positive feedback’ occurs to reinforce any downward shiftin sentiment, adjustment can be disruptive. The ‘elasticity pessimism’ of the tradeaccount is relevant here. If the trade account responded quickly and substantiallyto changes in the exchange rate, this would smooth the adjustment process. Justas a responsive, well-integrated, outward-looking production sector (characterisedby high price elasticities on international trade equations and, often, a high ratioof imports and exports to GDP) allows short-term shocks to ‘spill’ into the externaleconomy easily and protects the domestic economy from inflationary disruption,close integration facilitates longer-term adjustment.


Appendix A: Estimation of Import Equations

A.1 The General Approach

In Wilkinson (1992), the demand for imports was modelled as the excessdemand for importables. The demand for imports is, therefore, shown to be afunction of the relative prices of importables, exportables and non-traded goods,real income and production capacity in the Australian economy.

Wilkinson estimates equations for total and endogenous imports, usingtechniques appropriate for the analysis of non-stationary time series. Firstly, it isestablished that the series involved are non-stationary, possessing at least one unitroot. Secondly, an OLS regression is carried out on the log levels of the variablesand the residuals from this equation are tested for stationarity. If the residuals arestationary, the variables are said to be cointegrated and the equation represents along-run relationship between the variables. Thirdly, a ‘short-run’ equation isestimated, where the change in the dependent variable is modelled as a functionof lagged changes in itself, lagged changes in other explanatory variables and thelagged residual from the long-run equation (which represents the deviation fromlong-run equilibrium). This approach yields long-run and short-run elasticities forimports.

A.2 Some Simple Models

The general approach described above was used to estimate price and incomeelasticities for the different categories of imports. Each category of imports wasmodelled as a function of an activity variable and a relative price. Table A1 showsthe explanatory variables used for each equation. The specifications are moresimple than Wilkinson’s aggregate model in that they exclude the relative price ofexports and capacity constraints.

For each type of import, an activity variable was selected which was thought tobest reflect the demand factors driving imports. Consumption imports werethought to depend on private consumption. Likewise, capital imports werethought to depend on investment but, as reported below, the results were notsatisfactory using this variable. A second model was therefore estimated forcapital imports using total domestic spending (GNE) as an explanatory variable.This variable should capture the derived demand nature of investment and capitalgoods. ‘Other’ imports are essentially intermediate goods and demand for thesewill also be a derived demand. Non-farm product is therefore used as anexplanator, although there are clearly any number of different variables whichcould be used instead.


Table A1: Disaggregated Import Equations

Type of Import Explanatory Variables

Consumption (CM) • Real private consumption (PC)• Relative price of consumption imports (RPCM).

Consumption imports deflator/privateconsumption deflator

Capital (KM) Version 1• Real investment in plant and equipment (IPE)• Relative price of capital imports (RPKMI).

Capital imports deflator/IPE deflator

Version 2• Real gross national expenditure (GNE)• Relative price of capital imports (RPKMG).

Capital imports deflator/GNE deflator

Other (OM) • Real gross non-farm product (NFP)• Relative price of other imports (RPOM). Other

imports deflator/price of home-produced inputsto manufacturing

For consumption and capital imports, the relative price of each particular typeof import is defined with reference to the price deflator associated with the relevantactivity variable. For other goods, however, the relative price is defined using aprice index of home-produced inputs for manufactures.

The sample period for these disaggregated categories is only 12 years. Thispresents some difficulties in assessing the long-run properties of the seriesinvolved and estimating long-run relationships in the manner described above.The results should, therefore, be assessed with this problem in mind.

A.3 Time Series Properties of the Data

Wilkinson (1992) found both total endogenous imports and real GNE to exhibitnon-stationary properties over the period September 1974 to September 1989.Table A2 presents Augmented Dickey-Fuller (ADF) tests and Zt tests for non-stationarity of the additional series used here. The null hypothesis for both tests isnon-stationarity, so rejection of the null implies stationarity. All series are in loglevels and seasonally adjusted.

The null hypothesis of non-stationarity is accepted for the log level of everyseries at the 5 per cent level of significance. Non-stationarity of the first differences


Table A2: Unit Root Tests

Variable Sample ADF Zt

PC 59:3-92:4 level -2.58 -2.661st difference -10.53 -10.61

IPE 59:3-92:4 level -1.80 -2.271st difference -16.01 -16.03

NFP 59:3-92:4 level -2.26 -2.471st difference -12.25 -12.32

CM 79:3-92:4 level -1.01 -1.111st difference -6.60 -6.74

KM 79:3-92:4 level -2.29 -2.521st difference -3.09 -6.61

OM 79:3-92:4 level -1.38 -1.361st difference -6.87 -7.09

RPCM 79:3-92:4 level -1.56 -1.891st difference -7.48 -7.71

RPKMI 79:3-92:4 level -1.82 -2.081st difference -6.53 -6.66

RPKMG 79:3-92:4 level -1.61 -1.891st difference -3.29 -6.62

RPOM 79:3-92:4 level -1.29 -1.361st difference -6.47 -6.57

Notes: (a) Tests of the null hypothesis that the series has a unit root.(b) The ADF tests were constructed to include as many lagged differences as was necessary for the

elimination of serial correlation; LM tests for first and first-to-fourth order serial correlationwere used for this purpose. The Zt tests used five lags of the covariance.

(c) All the tests in Table A2 include a constant. The critical values from Fuller (1976) are -3.51 atthe 1 per cent level and -2.89 at the 5 per cent level.

is rejected at the 5 per cent level for all series and at the 1 per cent level for most,indicating the presence of one unit root in the levels.

A.4 Estimation

With evidence of non-stationarity, cointegrating relationships between therelevant variables were estimated. The Phillips and Hansen (1990) technique wasused to estimate the following equation for each type of import:

Mt = α +βACTt + γRPt +ut (A1)


where Mt is the (log of the) relevant import series at time t; ACTt is the (log of the)activity variable corresponding to the import category; and RPt is the (log of the)relevant relative price series.

Table A3 presents the estimates of the coefficients obtained from this procedure.The estimation of the cointegrating relationship for other imports indicated thatthe relative price term was insignificant at the 5 per cent level so the equation wasalso estimated without relative prices.

The null hypothesis of non-cointegration is rejected at the 10 per cent level forcapital imports when GNE is used as an explanatory variable. For other importswithout relative prices, non-cointegration can be rejected at the 5 per cent level;relative prices are, therefore, unnecessary for cointegration. On the other hand, thenull hypothesis cannot be rejected for consumption imports or for capital importswhen IPE is used as an explanatory variable.

These results are unexpected. Given that total imports have been found to becointegrated with demand and relative prices, we would expect the individualcomponents to be cointegrated with relevant components of demand. Onedifficulty might be the relatively short sample period. As a second test ofcointegration, the residuals from the Phillips-Hansen estimation (Res) are used

Table A3: Long-Run Elasticities Estimated from Equation A1

Components of Imports β γ ADF Zt

Consumption 1.73 -0.70 -2.76 -3.06(17.76) (-5.15)

Capital (using IPE) 1.41 -0.91 -2.64 -2.60(8.38) (-1.86)

Capital (using GNE) 1.40 -0.76 -3.56 -3.69(5.48) (-2.29)

Other 1.48 -0.18 -3.93 -3.82(12.01) (-1.53)

Other (excluding relative prices) 1.33 — -3.82 -3.77(14.69)

Notes: (a) t statistics are in brackets.(b) The null hypothesis for the ADF and Zt tests is non-stationarity (or non-cointegration). The

critical values (from Phillips and Ouliaris (1990)) are -3.77 at the 5 per cent level and -3.45 atthe 10 per cent level. For the other imports equation without relative prices, the critical valuesare -3.37 and -3.66 respectively.


in estimating a model of the form:

∆Mt = Σ αi∆Mt–i + Σ βi∆ACTt–i + Σγi∆RPt–i + θRest–1 + ut

l

i = 1

k m

i = 0 i = 0(A2)

If θ, the coefficient on the lagged residual, is significant, this is evidence ofcointegration. The error-correction models for each category of imports arepresented in Table A4. The approach used was one of general-to-specific modelling.Each equation started with four lagged changes of each variable and was testeddown to give a more parsimonious representation.

In the cases of consumption and other imports, θ is significantly different fromzero, which is evidence of a cointegrating relationship between imports, activityand relative prices. This is also the case for capital imports when GNE is used asthe activity variable. When IPE is used as an explanatory variable for capitalimports, however, the results are not as clear-cut.25 When included in the mostgeneral specification of the ECM for capital imports, the coefficient on the residualis insignificantly different from zero. As the model is tested down, however, itgradually becomes significant. The lack of consistency in this reinforces the initialevidence that cointegration between capital imports, IPE and relative prices istenuous.

The short sample period may also mean that the long-run elasticity estimatesreported in Table A3 are biased (see Inder (1991)). One simple check on theestimates is to see if they seem broadly consistent with the results obtained foraggregate imports which were estimated over a longer time period. The averageof the income and price elasticities (giving more weight to other imports) arearound 1.5 and -0.5, respectively - very similar to the aggregate estimates. Thissuggests that the long-run elasticities are not too biased.

A second consistency check on the long-run elasticities was carried out byestimating an unrestricted error-correction model (ECM) for each category ofimports. The model estimated was of the form:

∆Mt = µ + Σ αi∆Mt–i + Σ βi∆ACTt–i + Σγi∆RPt–i

+ AMt–1 + BACTt–1 + CRP t–1 + ut

l

i = 1

k m

i = 0 i = 0(A3)

The long-run elasticities are easy to calculate from this formulation. Theincome elasticity is -B/A and the price elasticity -C/A. The standard errors for thelong-run coefficients cannot be calculated, so the statistical significance of the

25. These results are not reported here but are available on request.


Table A4: Error-Correction Models

Consumption imports - DCMPeriod of estimation: 1980:2 to 1992:4Variable Coefficient Standard error t statisticResidualt-1 -0.416 0.104 -4.011DCMt-2 0.276 0.104 2.647DPCt 2.464 0.500 4.926DRPt -0.343 0.163 -2.111

R2 0.508Adjusted R2 0.477DW 1.802SSR 0.064SEE 0.037

Capital imports - DKMPeriod of estimation: 1980:2 to 1992:4Variable Coefficient Standard error t statisticResidualt-1 -0.338 0.089 -3.78DGNEt 0.838 0.499 1.680DGNEt-1 0.805 0.448 1.796DGNEt-2 1.749 0.492 3.554


Other imports - DOMPeriod of estimation: 1980:1 to 1992:4Variable Coefficient Standard error t statisticResidualt-1 -0.761 0.118 -6.446DOMt-1 0.265 0.113 2.347DNFSt 0.391 0.097 4.035



elasticities from this formulation cannot be tested.26 However, it does give someindication of how robust the point estimates of the long-run elasticities are todifferent estimation techniques. Table A5 reports the long-run elasticities estimatedfrom equation (A3).

26. The Bewley transformation can, in theory, be used to derive valid t statistics for the long-runcoefficients.

27. Ostry and Rose (1992) construct a similar measure for testing if tariffs have any macroeconomiceffects. This is clearly an imperfect measure: it excludes import quotas and other non-tariffbarriers (although it does correspond, in its broad movements, with the measure of effectiveassistance shown in Figure 5). Furthermore, where tariffs are prohibitive, revenue collectionwill be negligible.

The estimates of the long-run elasticities derived from equation (A3) are verysimilar to those obtained from the Phillips-Hansen technique, except for capitalimports when IPE is used as the activity variable. In general, modelling capitalimports using IPE was not successful - there is limited evidence of a long-runrelationship and estimates of long-run elasticities are not robust to estimationtechnique. Estimates using GNE as an activity variable perform much better on allcriteria.

A.5 Incorporating Tariffs

Section 4.1.3 reports the results of adjusting the relative price term for tariffs.The adjusted relative price is defined as:

RPt =MIPDt(1 + Tt)

EIPDt(A4)

where MIPDt is the implicit price deflator for endogenous imports at time t, EIPDtis the implicit price deflator for domestic expenditure and Tt is the tariff rate. Therelative price of consumption imports is defined analogously, using the IPD forconsumption imports and the IPD for domestic consumption. The tariff is definedas the ratio of customs duty receipts to the total (free-on-board) value ofendogenous imports.27

Table A5: Long-Run Elasticities from Unrestricted ECM

Components of Imports Income Relative Price

Consumption 1.8 -0.8Capital (using IPE) 0.4 -3.2Capital (using GNE) 1.3 -0.6

Other 1.4 —


Section 4.1.3 also reported the results of two other tests for the role of tariffs.The first included the effective rate of assistance as a separate explanatoryvariable. The second test introduced a new relative price variable (RP2), replacingthe free-on-board import price with the imported component of the consumer priceindex (CPI). Although this variable only captures tariffs on items in the CPIbundle, it does represent a final retail price.

Table 9 in the text reported the elasticities estimated using the Phillips-Hansentechnique. In order to test if there is evidence of a cointegrating relationship, theresiduals from the three equations were used in an error-correction model.Table A6 reports the coefficients and t statistics on the lagged residuals when themost general model is specified with three lagged changes in all variables.

Table A6: Significance of Lagged Residual in ECM

Model Coefficient on Standard Error t statisticresidual t-1

i -0.227 0.082 -2.776ii -0.481 0.190 -2.536

iii -0.854 0.217 -3.929

In each case, the coefficient on the lagged residual is significant at the 5 per centlevel, evidence of cointegration.

A.6 Data Sources

Data on Gross National Expenditure (GNE), Private Consumption (PC), GrossNon-Farm Product (GNFP), Investment in Plant and Equipment (IPE), Non-FarmStocks (NFS) and their deflators are available from the Australian Bureau ofStatistics (ABS), Australian National Accounts, Catalogue No. 5206.0.

Data on endogenous imports, consumption imports, capital imports, otherimports and their deflators are available from the ABS, Balance of Payments,Australia, Catalogue No. 5302.0.

Data on the price of home-produced inputs to manufacturing are available fromthe ABS,Price Indexes of Materials used in Manufacturing Industries, CatalogueNo. 6411.0.

Data on computer import values and volumes are unpublished and non-seasonallyadjusted ABS data. Standard International Trade Classification categories 752and 75997 are used.


Data on customs duty receipts are available from the Department of Finance,Commonwealth Financial Transactions (monthly).

The effective rate of assistance to manufacturing was derived by splicingshorter-run series published by the Industry Commission (Plunkett, Wilson andArgy 1992).

The imported component of the CPI is available from the ABS, Consumer PriceIndex: Effect of Changes in Prices of Imported Items, Catalogue No. 6444.0.


Appendix B: Econometric Estimates for Manufactured Exports*

B.1 The General Approach

The log-linear specification of (1) in the text can be written as:

xit = αi + Σ υjvj + εit

k

j=1(B1)

where lower case letters represent logs and the vj are the k explanatory variablesin (B1). A more general specification that allows a long-run equilibrium relationshipwith short-run dynamics is an autoregressive distributed lag model with two lags:

xit = αi + δ1xit–1 + δ2xit–2 + Σ (υj0vjt + υj1vjt–1 + υj2vjt–2) + εit

k

j=1(B2)

This can be re-parameterised as an unrestricted error-correction model (UECM):

∆xit = αi + β0xit–1 + β1∆xit–1 + Σ (γj0vjt–1 + γj1∆vjt + γj2∆vjt–1) + εit

k

j=1(B3)

where: β0 = δ1 + δ2 – 1β1 = −δ2

γj0 = υj0 + υj1 + υj2

γj1 = υj0

γj2 = –υj2

In this form, the long-run elasticities are –γj0

β0, etc.

As a first step, a basic UECM specification was estimated; the volume ofmanufactured exports was modelled as a function of the relative price ofAustralian manufactured exports and foreign country output. In the context of thisbasic model, other variables were added to see if they added significant explanatorypower.

B.2 Panel Estimation Issues

For the basic model, it was assumed that individual country effects wererestricted to the intercept coefficients.

In dealing with the individual country effects, it was decided to use a fixedeffects model, rather than a random effects model, as the individual effects arelikely to be correlated with the other regressors, especially foreign country

* Denzil Fiebig provided some technical advice regarding the estimation procedure.The authors are responsible for any errors.


output.28 Further, unlike panel estimations based on cross-sections of persons, thedata from this cross-country panel are measurements of populations, rather thanof individuals. This also implies that, in this case, the individual effects are lesslikely to be random in nature.

Estimating dynamic models within a fixed effects framework is problematic.It is well known that the fixed effects estimator is inconsistent when the set ofregressors contains lagged dependent variables and the sample is finite in the timedimension.29 This is because, within each country, each disturbance term iscorrelated with every observation of the dependent variable. This leads toinconsistent parameter estimates.

This problem can be corrected by instrumental variables (IV) estimation.However, there is a difficulty selecting suitable instruments for xit–1, and ∆xit–1since in the probability limit the instrument should be correlated with the laggeddependent variable and uncorrelated with the error terms. Clearly, any lag ofmanufactured exports to countryi is an unsuitable choice for an instrument, sinceall observations within countryi are correlated with all of the disturbances for thatcountry. ∆∆xit–1, was considered as an instrument, but was found not to be wellcorrelated with the level of xit–1 or ∆xit–1 .

It was decided, instead, to use manufactured exports to a third country as aninstrument - that is, the instrument for xit–1, was xjt–1, i ≠ j. Exports can be expectedto be correlated across countries because:

• shocks affecting the supply of Australian exports will impact across allcountries; and

• the macroeconomic shocks that affect demand for manufactured exports willbe correlated across countries, inasmuch as business cycles are correlatedinternationally.

The variables used as instruments for the lagged dependent variable wereconstructed in the following way. A correlation matrix was computed for the 21dependent variable series. For the manufactured export series of each country, theseries with the highest correlation was identified. These series were then ‘stacked’to form a new variable, the lag and lagged differences of which were used asinstruments in the IV estimation.

These instruments can be assumed to be uncorrelated with the disturbanceterms, since the use of the fixed-effects model does not imply anything about thecorrelation of the dependent variable and the disturbance terms across countries.

28. For a discussion of the relative merits of fixed versus random effects models, see Hsiao (1986,pp. 41-47.)

29. See Hsiao (1986, pp. 73-76) for a proof.


One of the advantages of panel data estimation is that it is no longer necessaryto assume the stationarity of the dependent variable and regressors as a conditionfor the asymptotic normality of the disturbance terms.30 This is because the effectof the nuisance parameters distorting the disturbances can be made to approachzero by letting N → ∞ while keeping T finite.

B.3 The Choice of the Relative Price Measure

The response of manufactured exports to movements in relative prices willdepend on the measure used. A fall in the price of Australian manufactured exportsrelative to the price of manufactures from other sources will generally lead to anincrease in demand for Australian exports. For a foreign consumer, the alternativesto Australian manufactures are, firstly, exports from third countries, and secondly,local goods produced by import-competing firms. In the first case, the world priceof manufactured exports will be relevant. The ‘world’ relative price is, therefore,defined as the price of Australian manufactured exports relative to the world priceof manufactures. In the second, it is possible that the price of local manufacturingproduction may exert an independent effect on the volume of Australianmanufactured exports. The ‘bilateral’ relative price is, therefore, defined as theprice of Australian manufactures relative to the price of domestically producedmanufactures in each country.

The relationship between the price of manufactured exports and supply is lesscertain. If the price of exports falls relative to the price in the domestic market,manufacturers may find it more profitable to supply the local market and hencereduce exports. If, on the other hand, exporters have some degree of market power,then a fall in the relative price of exports may reflect cost reductions due toincreases in productivity specific to exporters. This is likely to be the case ifexporters, by being exposed to international competition, achieve faster productivitygrowth than firms selling only to the domestic market.

B.4 Estimation Procedure and Results

Initially, the basic model was estimated with both world and bilateral relativeprices and with two lags of each variable. Income elasticities were constrained tobe equal across countries. The results indicated that the world relative price hada significant influence on manufactured exports, whereas an additional effect frombilateral relative prices was not significant. This is consistent with a situationwhere the prices of import-competing manufactures in other countries aredetermined by the world price of manufactured exports. Given the lack ofsignificance of bilateral relative prices, this variable was dropped from subsequentestimations.

30. See Goodrich and Caines (1979) for a proof.


It was found that the second lags of all variables were not jointly significant, andthe final basic specification was as follows:31

∆xit = αi + β0xit–1 + β1∆xit–1 + ω0wt–1 + ω1∆wt + ω2∆wt–1 +

η0yit–1 + η1∆yit + η2∆yit–1 + εit (B3)

This specification was used as the basis for subsequent tests of the significanceof the other variables mentioned above, the results of which were reported inTable 10 in the text.

In order to test the equality of income elasticities across countries, the basicmodel with the effective rate of assistance was re-estimated, allowing incomeelasticities to vary. Results for this estimation are reported in Table B1.

Individual estimates for foreign country output terms were mostly insignificantand so are not reported. However, the joint test of the significance of these termswas χ2(63) = 407.8 and the null hypothesis could be rejected at the 1 per centsignificance level. The hypothesis that the coefficients on the various foreign

31. The joint test of the significance of all second lags and the bilateral relative price terms wasχ2(7) = 7.36. The null hypothesis that the coefficients on these terms were equal to zero,therefore could not be rejected even at the 20 per cent confidence level.

Table B1: Income Elasticities Varying Across Countries

Coefficient Standard SignificanceEstimate Error Level

Exports

xit–1 -0.33 0.11 0.01

∆xit–1 0.28 0.32 0.38

World relative prices

wt–1 -1.55 0.58 0.01

∆wt -1.55 0.68 0.02

∆wt–1 0.52 0.45 0.27

Effective rate of assistance

zt–1 -1.17 0.32 0.25

∆zt–1 0.12 0.62 0.84

∆zt–1 1.45 0.79 0.07

Notes: R2

= 0.37, SSR = 23.4, SEE = 0.32.


output terms were equal across countries was also rejected at the 1 per centsignificance level.

With regard to the other variables, the long-run elasticities for world relativeprices and the effective rate of protection were -4.7 and -3.5, respectively. Theseresults are similar to those obtained from other estimations.

B.5 Error Structure

To test for heteroscedasticity related to the cross-sectional nature of the data,Breusch-Pagan tests were conducted using country dummies as explanatoryvariables. In all cases, the null hypothesis of no heteroscedasticity was rejected atthe 1 per cent level of confidence.

Lagrange multiplier tests for up to fourth order autocorrelation were conducted.In all cases, the null hypothesis of no autocorrelation was rejected at the 1 per centlevel of confidence. Varying lag lengths did not appear to markedly affect theseresults.

Unless corrected for, the presence of heteroscedasticity and autocorrelatederrors would lead to inconsistent estimates of the standard errors. Accordingly,Newey-West standard errors have been reported for each estimation.

B.6 Structural Stability

Menzies and Heenan (1993) reported evidence of a structural break in thebehaviour of Australian manufactured exports in the late 1980s. To test this withthe panel data, Chow tests for a break in the relationship from 1986 onwards wereconducted for each model. In all cases, the null hypothesis of stability of thecoefficient estimates could not be rejected at the 5 per cent level of significance.

B.7 Data Description and Sources

The panel consists of a balanced sample of 21 countries with annual data from1977 to 1991. The countries were selected on the basis of their importance asmarkets for Australian manufactures, as well as data availability. The full list ofcountries is shown in Table B2.

The definition of manufactures used in this study is Standard InternationalTrade Classification (SITC) Sections 5 to 8, excluding Divisions 67 and 68. Thiscorresponds to the categories ‘Transport’, ‘Machinery’ and ‘Other Manufactures’as classified in the Australian Bureau of Statistics (ABS) publication Balance ofPayments, Australia, Catalogue No. 5302.0. Current price estimates of exportvalues at a SITC division level for various countries from 1982 to 1991 wereobtained from the Central Statistics Section, Department of Foreign Affairs and


Table B2: Countries included in Estimation

Canada Italy South Korea

China Japan Sweden

France Malaysia Switzerland

Germany Netherlands Taiwan

Hong Kong New Zealand Thailand

India Philippines United Kingdom

Indonesia Singapore United States

Trade. Prior to 1982, these series were obtained from OECD Foreign Trademagnetic tapes. Adjustments were made to correct for a break in 1978 due to thechange from SITC Revision 1 to SITC Revision 2.

Constant price estimates were calculated at a SITC division level usingdeflators provided by the ABS. These were then aggregated to obtain the finalconstant price estimates for manufactured exports to each country.

The world relative price is the ratio of the manufactured exports deflator(balance of payments basis) to the unit value of world manufactured exports. Thelatter series is obtained from GATT (1992).

Bilateral relative prices are the ratio of the manufactured exports deflator to theprice of domestically manufactured goods in each country. The latter series wereobtained from the World Bank (1992). Missing observations were replaced usingspliced producer or consumer price series obtained from the IMF’s InternationalFinancial Statistics. The exchange rates used were period averages published inthe IMF’s International Financial Statistics.

The domestic relative price is the ratio of the manufactured exports deflator tomanufacturing producer prices (excluding petroleum). The latter was obtainedfrom the ABS, Price Indexes of Articles Produced by Manufacturing Industry,Australia, Catalogue No. 6412.0.

Foreign country output is (in general) real gross domestic product, obtainedfrom the IMF’s International Financial Statistics. Data on real Australian GNEwere obtained from the ABS, Australian National Accounts, Catalogue No. 5206.0.

The measure of capacity utilisation was taken from the results of theACCI/Westpac Survey of Industrial Trends. The net balance of respondentsindicating an increase in capacity utilisation (plus 100 to avoid negative values)was used. The effective rate of assistance to manufacturing was derived bysplicing shorter-run series published by the Industry Commission (Plunkett,Wilson and Argy 1992).


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